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Industry Domination Is Not Enough

Do the airline, pharmaceutical, or software industries have what it takes to spawn a Rule Maker investment?

Last week, I argued the Rule Maker Portfolio would be better served if it spent more time analyzing companies that better matched our knowledge and expertise. While it's hard not to get excited about the growth opportunities in technology, there are other industries the portfolio should devote more time to.

This is something that's been discussed often at Fool HQ. We always receive emails with comments like, "Why don't you look at Disney(NYSE: DIS) or Southwest Airlines(NYSE: LUV)?" Indeed, these are well-run, successful companies, but both have similar shortcomings: neither is in a Rule Maker industry.

Examining an industry is the first step in finding Rule Makers. Disney and Southwest dominate their industries, but it takes more than that to become a Rule Maker. There's a list of criteria companies must meet, or at least show promise to fulfill in the future. If industry domination were all it took, I'd argue we invest in AT&T(NYSE: T), to the delight of every grandma that owns it.

Despite the inherent difficulties of the airline industry, Southwest has become the crï¿½me de la crï¿½me of the industry, creating significant shareholder wealth throughout the last five years (see chart below). You need not look any further than its most recent quarter to understand why. Southwest met earnings expectations of $0.15 per share, while the rest of the industry struggled.

Delta (NYSE: DAL) lost $1.02 per share, well below lowered estimates of $0.85 per share. The parent of United Airlines, UAL (NYSE: UAL), missed its estimate for a loss of $4.28 per share, posting a loss of $5.82 per share. Northwest Airlines (Nasdaq: NWAC) and American parent AMR (NYSE: AMR) posted narrower-than-expected losses, but that was still a far cry from Southwest's 27% profit growth.

There are a number of reasons why investors shouldn't consider investing in the airline industry. First, profit margins are low because the costs of owning and operating planes are enormous. The capital expenditure requirements are also high because planes and hangars are expensive to buy. This makes it extremely difficult to produce free cash flow or generate a positive return on invested capital.

Large debt balances have also forced companies like Branniff, Eastern, and Pan Am into bankruptcy, and airlines are constantly plagued with labor issues and hyper fuel costs. It's these problems that make a recent Warren Buffett quote regarding the industry ring true. "If capitalists had been present at Kitty Hawk when the Wright Brothers' plane first took off," said Buffett, "they should have shot it down.

Truthfully, Southwest has been able to escape many of these difficulties. It's avoided thorny labor issues, for example, because its union leader ship has a long-range view, placing the sustainable profitability of the airline above salary disputes. Nevertheless, while Southwest dominates its space, the shortcomings of the airline industry are too great for it to ever become a Rule Maker.

Looking at the holdings in our portfolio, it's clear some industries are overflowing with Rule Makers. In the pharmaceutical space, for example, we own Schering-Plough (SGP), Pfizer(NYSE: PFE), and Johnson & Johnson(NYSE: JNJ). There are most likely other Rule Maker companies in this industry, given the inherent competitive advantages: long product cycles and monopolistic characteristics.

With companies like Microsoft (Nasdaq: MSFT) and Oracle (Nasdaq: ORCL) driving it, the software industry also has plenty of financial and business model advantages -- including excellent gross and net profit margins, low Foolish Flow Ratios, and low capital expenditures -- that breed ideal Ruler Maker candidates. The industry has low margins because the costs for initially creating software can be substantial, but the costs for licensing and replication are near nothing.

Software companies are also able to operate without any inventory. Software applications are digital, which means they're stored and distributed electronically. That cuts down working capital requirements, spurs excellent returns on invested capital, and leads to very low Flow Ratios. This type of digital distribution also means companies can get paid quickly, which creates lots of incoming cash.

With some industries breeding Rule Makers while others don't, we're led to ask: Where should we look next? The consumer goods sector seems as good as any, particularly because it has so many exciting brand names. It's potentially easier to understand the business direction, global relevance, and future results of companies in this sector.

High-end jewelry retailer Tiffany(NYSE: TIF), for example, has been on our Rule Maker watch list for some time. It's built a dominant brand thanks in great part to its signature blue box, a symbol of Tiffany's quality craftsmanship and superior merchandise. But as we said earlier, before looking at Tiffany, let's first begin by examining the industry. We'll start that process next week, but in the meantime head to the Rule Maker message board and tell us where you think potential Rule Makers might be.